Larry Ribstein on Free to Lose?

Larry E. Ribstein is the Mildred Van Voorhis Jones Chair in Law and the associate dean for Research, University of Illinois College of Law

I thought I’d aim my opening post at the question that motivated my interest in this symposium: is behavioral economics leading us to the end of free markets and the takeover of the regulatory state?

Consider how far we’ve come since the days of “caveat emptor,” when sellers had a legal right to fool and cheat buyers, and consumers were free to be fooled and cheated.

At some point we entered the age of disclosure. Disclosure regulation could be rationalized in the name of consumer sovereignty. Freedom is arguably not much good when it’s just another word for losing money to sellers. Of course disclosure laws can be misguided or excessive. At their worst they are just another way to regulate conduct — e.g., mandatory proxy disclosures about executive compensation.

Behavioral economics tells us, however, that just giving consumers some information is not enough. Indeed, disclosure becomes part of the problem. New information can’t help people who are “anchored” in old information, or simply use it to “confirm” their initial judgments. Consumers might over-rely on the parts of the disclosures that are most “available” or erroneously “frame” the information presented. Some of these errors might be corrected by getting the disclosures just right, but others might be unaffected or exacerbated. A decade ago an article listed almost 40 research topics relating to behavioral finance, which is just one branch of behavioral economics, many identifying distinct theories concerning behavioral biases.

Behaviorism-based regulation has no clear stopping point because everybody makes mistakes that can be attributed to some heuristic flaw. Consider a leading experimental study of mutual fund investing by Harvard staff members, Wharton MBA students and Harvard college students. The Harvard staffers were mostly college educated and the students reported average SAT scores in the 98th and 99th percentiles. The study showed that the participants failed to choose among basically identical index funds so as to minimize fees. If we can’t trust these consumers to make simple financial decisions, whom can we trust?One has to wonder whether the problem that behaviorism is solving is really one with markets. These calls for increased regulation come at a time when markets would seem to be more robust than ever. The internet and increased international trade offer consumers endless choices and mountains of easily accessible information. Increased market efficiency seems to have taught us only that markets are not the answer because we ourselves are the problem.

This leads to behaviorism’s counterpart, what might be called governmentism. If behaviorism reveals that our choices are not as rational as we thought, governmentism is the irrational belief that government is better able to fix this problem than we think it is. And this must be the federal or even global government because if we don’t trust markets we should not trust markets for law.

The real question is not whether consumers’ judgments are fallible, but whether we should trust government more than consumers. Consider that it does not necessarily follow from any revelation of flawed heuristics that a particular regulation will fix the flaw rather than having no effect or making things worse. Moreover, even if a clever theoretician can imagine a seemingly foolproof solution, there is no reason to believe that legislators or bureaucrats will adopt that solution or something close to it. After all, politicians and bureaucrats are people too. This suggests, as Choi and Pritchard have written, that they’ll make the same errors behaviorists attribute to consumers. And even perfectly rational legislators can be expected to self-maximize rather than acting in the public interest. This means that actual laws, as distinguished from those scholars imagine, reflect the demands of competing interest groups, including firms themselves, rather than consumers’ needs.

Perhaps behaviorism only teaches us not to put too much trust in another set of scholars — those who seek to base regulation on rational choice-based economics. But behavioral economics generally looks at mistakes by individual actors. Markets may be rational despite these mistakes as long as a critical mass of market actors keep their heads rather than following crowds, and sellers have only a limited ability to price-discriminate.

This leaves us with a philosophical question. When in doubt, should we err on the side of trying to use government to perfect people, or should freedom itself be a value? In other words, is it best to give people the freedom to err, unless we’re very sure that government can help? I would generally rather have the freedom to leave a few more bucks on the table for a seller clever enough to scoop it up than pay a bureaucrat or politician to save me from my mistake, even if, indeed, it is a mistake.

Larry Ribstein

5 responses to Larry Ribstein on Free to Lose?

Larry: “The real question is not whether consumers’ judgments are fallible, but whether we should trust government more than consumers. Consider that it does not necessarily follow from any revelation of flawed heuristics that a particular regulation will fix the flaw rather than having no effect or making things worse. Moreover, even if a clever theoretician can imagine a seemingly foolproof solution, there is no reason to believe that legislators or bureaucrats will adopt that solution or something close to it. After all, politicians and bureaucrats are people too. This suggests, as Choi and Pritchard have written, that they’ll make the same errors behaviorists attribute to consumers. And even perfectly rational legislators can be expected to self-maximize rather than acting in the public interest. This means that actual laws, as distinguished from those scholars imagine, reflect the demands of competing interest groups, including firms themselves, rather than consumers’ needs.”

I agree. Frankly, my experience as a portfolio manager is that there is a great deal of merit in some of the behaviorists’ assumptions. Markets are not and can never be completely efficient, although the largest and most liquid markets tend towards efficiency under normal conditions. There will always be an element of irrationality which under some circumstances (illiquid markets, unusual and poorly understood instruments, periods of extreme exuberance or widespread discouragement) dominates over the aggregate tendency of market participants to neutralize all these factors. But as you say, governments are subject to the same behavior constraints as the normal market participants; worse, through the desire of politicians to win more popular support or power, they may exaggerate them.

This does not mean that ‘no regulation’ is always the best policy. And as markets evolve, it may be that new problems are created/discovered, which may require further regulation. (Concomitantly, some prior regulations may turn out to have outlived their usefulness, and can safely be abolished.) But great care should always be exercised, and sufficient time allowed to lapse that it be clear that the regulatory response is not another aspect of the same outbreak of irrationality as that which revealed the new ‘problem.’ And the delicate balancing act between freedom and protective rules-making must always be seriously considered.

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